Download I. Measuring Output: GDP

University of California-Davis
Economics 1B-Intro to Macro
Handout 3
TA: Jason Lee
Email: [email protected]
I. Measuring Output: GDP
As was mentioned earlier, the ability to estimate the amount of production in an economy
is an important one in macroeconomics. The variable used to estimate production is
called Gross Domestic Product (GDP). GDP simultaneously measures both the total
production in an economy and the amount of income earned in an economy. GDP is also
important because it is frequently used as a measure of well being. Developed countries
such as the United States have GDP per person that is 35 to 40 times greater than GDP
per person in several sub-Saharan countries.
A. GDP: The Definition
Gross Domestic Product has a very precise definition that allows you to tell whether or
not a transaction is part of GDP. It is very important that you learn this exact definition.
GDP is the total market value of all the final goods and services produced within an
economy in a given year.
Here are some of the key takeaways you should get out of the definition.
1. “FIAL GOODS AD SERVICES”: GDP only includes the value of the finished
product that is sold. The value of any inputs or goods that were used up in the production
process (intermediate goods) is not included in GDP. The reason we don’t include
intermediate goods is that it is assumed that the value of production is already included in
the final price of the end good.
Example: Suppose that McDonald’s sells a Big Mac for $2.50. Since this is the final
good the $2.50 would be included in GDP. However, suppose a cattle rancher sold the
beef patty to McDonald’s for $1. The patty is an intermediate good and thus the $1 is not
included in GDP.
2. “WITHI A ECOOMY”: GDP only includes the value of products that are
produced within the borders of an economy.
Example: A Mexican national who works in the United States would see his income
included in U.S. GDP because his work occurred within the country. On the other hand,
if Ford Motor Company opened a car factory in Mexico, the value of the production of
the factory would not be included in U.S. GDP even though Ford is an American
company.
3. “I A GIVE YEAR”: GDP only includes the value of new goods that are
produced during the current year. This part of the definition would exclude all used
goods that are bought and sold in the economy. The reason why is that these goods were
previously counted in an earlier year’s GDP measure and we would not want to count it
again.
Example: A new house built this year would be included in GDP calculations, but a
house built in 1998 sold this year would not be included in GDP.
B. GDP: The Components
Now that we have a basic idea of what is and is not included in GDP, we can now
categorize each transaction. GDP can be broken down into 4 broad categories. These
categories are:
1. Consumption (C): These are purchases by consumers. Consumption can further be
broken down as:
• Durables: Things that last for several years (think refrigerators or cars)
• Nondurables: Things that don’t last that long (think food, toilet paper)
2. Investment (I): These are purchases by firms. There are three main types of
investment.
• New factories and machines (firms)
• New Housing (households)
• Inventories (firms)
3. Government (G): Purchases by government. This component includes purchases of
goods as well as services. Important components not included are transfer payments
(Social Security, welfare, food stamps, etc…). The reason why transfer payments are
not included is because nothing is actually being produced when the government transfers
funds from one group (taxpayers) to another group (elderly receipts of social security).
4. et Exports (X): This component is simply the difference between the exports of a
country (the amount of domestic goods sold abroad) minus the imports (the amount of
foreign goods purchased domestically).
In the end we can write GDP as follows:
GDP = C + I + G + NX
C. Other Measures of National Accounting
While GDP is the widely accepted measure of national accounting, there are several other
measures that you should be familiar with.
1. Gross ational Product (GP): GNP differs from GDP in that it measures the total
production of nationals in a given year. That is the value of all production by American
workers and firms, regardless of location would be included in U.S. GNP. For example,
an American who works in France would be included in U.S. GNP (but not US GDP).
Similarly, a U.S. firm that has a factory in India would see the value of the factory’s
production included in U.S. GNP. For most countries, the difference between GDP and
GNP is not large. However, there are some countries with a large percentage of its
nationals living abroad (or who employ a high number of foreign workers) such that large
differences can occur.
2. et ational Product: This measure is just GNP minus depreciation. Depreciation
is the wear and tear of machinery.
3. ational Income: Net National Product minus some statistical discrepancies. What
is important here is that approximately 2/3 (65%) of national income is comprised of the
income of workers.
D. Calculating GDP
Up until now we have learned the components of GDP, now we focus on how to quantify
the value of these transactions. As you recall from the definition of GDP, we measure the
total market value of all goods and services produced in an economy.
Suppose we were asked to calculate the GDP of a very simple economy that produces
only 2 goods. Calculating the GDP for this economy would be very straightforward. We
would see how much of Good 1 was produced in the current year and multiply my the
current price (to get the market value of Good 1) and then do the same for Good 2. Thus
the formula for calculating GDP for 2 goods is
GDP = (PGood1 x QGood1) + (PGood2 x QGood2)
However, most economies produce millions of goods in a given year. But the principle is
still the same. In general, the formula for calculating GDP for N number of goods is:
GDP = (PGood1 x QGood1) + (PGood2 x QGood2) + (PGood3 x QGood3) +…+(PGoodN x QGoodN)
Consider the following example:
Suppose that Canada produces only two types of goods: Hockey Sticks and Celine Dion
CDs. In the following table are data for 2008:
Price of 1
Hockey Stick
2008
$10
Quantity of
Hockey Sticks
Produced
1000
Price of Celine
Dion CDs
$5
Quantity of
Celine Dion
CDs
5000
Calculate the GDP for Canada in 2008.
This GDP where we simply multiply current production by current prices is called
ominal GDP. In actuality, economists don’t often use Nominal GDP in measuring
output. The reason can best be seen in an example. Continuing with our Canadian
obsession, suppose that in 2009 the prices of all goods doubled while production stayed
the same:
Price of 1
Hockey Stick
2008
2009
$10
$20
Quantity of
Hockey Sticks
Produced
1000
1000
Price of Celine
Dion CDs
$5
$10
Quantity of
Celine Dion
CDs
5000
5000
What is the Nominal GDP for Canada in 2009? Comparing your answer to 2008 GDP
you find that Nominal GDP has doubled in 1 year. But it should be clear that Canada is
not twice as better off in 2009 than in 2008. In fact, most would argue that Canada is
worse off because they have experienced a doubling of prices with no increase in output
production. Increases in Nominal GDP can give a very misleading picture about the well
being of a population. We therefore need an alternative measure of GDP.
Real GDP uses base year prices when calculating GDP. There is some arbitrary year that
is called the base year and GDP is calculated using the prices of goods and services of
that year. Thus any changes in Real GDP from one year to the next would only occur
because of changes in the production level (since prices are fixed over time).
In general for N goods, the formula for Real GDP is:
Real GDP = (P1BaseYr x Q1) + (P2BaseYr x Q2) + … + (PNBaseYr x QN)
Note that the choice of base year is completely arbitrary. You’ll get different values of
GDP depending on what base year you choose. In order to mitigate this problem, a
chain-weighted index is used. This index takes the average of prices over several years
and uses that as the base price level. However, for this course we’ll generally ignore this
problem.
E. Using GDP to Measure Inflation
From our definitions of Real GDP vs. Nominal GDP we see that the only difference
between the two is that Real GDP uses a base year price while Nominal GDP uses
today’s current price. Thus any difference between the two variables would measure the
change of prices from the base year to the current year. Macroeconomists uses the ratio
of Nominal GDP to Real GDP as a way to measure how fast prices have changed over
time. This is known as the GDP Deflator
Formally the equation is written as: GDP-Deflator =
Nominal GDP
x 100
Real GDP
F. Shortfalls of Using GDP
While GDP is certainly a helpful measure of gauging the well-being of a country it does
have its limitations.
1. GDP does not measure household production (i.e. cooking, cleaning, taking care
of children).
2. GDP does not measure leisure. Individuals value leisure and perhaps an economy
where people work 35 hours per week (such as France) might have a higher level
of well-being than the United States even though France have a lower GDP per
capita.
3. GDP does not include the underground economy. GDP measures only
transactions that occur in the open. Any transactions that are either “under the
table” or completely illegal will not be included in GDP measures.
4. It does not account for environmental damage. A factory that produces steel will
have its output included in GDP, but the damage it might have caused to the air or
river would not be factored in to GDP calculations.
II. Measuring Prices (CPI)
A. The Consumer Price Index
When we talked about GDP we saw that we could measure the increase in prices by using
the GDP deflator. There is an alternative way to measure price increases called the
Consumer Price Index (CPI).
CPI measures the change in the value of a fixed basket of goods purchased by a typical
consumer. A base year is chosen (just like for Real GDP the base year is arbitrary) and
whatever an average consumer purchased in that year comprises the fixed basket.
Formally the CPI is calculated as follows:
CPI =
Value of the fixed basket in the current year
x 100
Value of the fixed basket in the base year
B. CPI vs. GDP-Deflator
We have two ways of measuring prices. What are the differences between them?
1. The GDP deflator by definition will not include any price changes of imports. Recall
that GDP measures only domestically produced goods and services. It’s not
unreasonable to assume that a typical consumer will purchase some foreign goods (such
as wine, televisions, cars, etc…). CPI index will be able to capture any price changes in
imports.
2. A problem with the fixed basket approach of the CPI is that it does not allow the
consumers to adjust for quantity purchased if prices go up. If the price of a good goes
up, consumers might purchase less of that good in response. In such cases the CPI will
overstate the impact of the prices. GDP deflator on the other hand takes into account
both quantity changes.
3. Another problem with the fixed basket approach is that new products are not
immediately included in the CPI. Suppose that the consumer price index base year was
1999. In 2009 goods such as iPods, GPS devices, Blu-Ray discs are being purchased by
typical consumers and any price changes in those goods would affect consumers.
However, since our base year is 1999 the CPI would not show any change if the prices of
those goods went up since those goods didn’t even exist 10 years ago.
4. The CPI index does not adjust for quality. A computer and a car that was purchased
that comprised a fixed basket 10 years ago is not the same thing as a computer and a car
purchased today. Any price increases would not take into account the quality
improvement and thus CPI would overstate the true increase in prices.
C. Inflation Rate
Whether we use GDP-deflator or CPI Index to measure prices, the formula to measure
inflation is the same for both.
Inflation Rate =
New Price Index - Old Price Index
Old Price Index